Debt-to-Income Ratio and Mortgages: Everything You Need to Know

debt-to-income-ratio-and-mortgages

If you’re saddled with student loan debt, the idea of buying a home may feel like a pipe dream. The good news is that it’s possible to save up for and purchase a house while you’re paying off student loan debt.

However, your student loan payment could get in the way of your eligibility for the home you want. More specifically, lenders use your debt-to-income ratio to calculate how much you can afford on a monthly basis, which then informs how much of a loan you can get.

So what is debt-to-income ratio, and how does it affect you and your house hunting plans? Here’s what you need to know.

What is debt-to-income ratio?

Your debt-to-income ratio, or DTI for short, is the percentage of your gross monthly income that goes toward debt payments. For example, if you earn $5,000 per month before taxes and $500 of that income goes toward your student loans, car loan, and credit cards, your DTI is 10%.

When you apply for a mortgage loan, lenders typically calculate two separate debt-to-income ratios: the front-end DTI and the back-end DTI.

The front-end DTI shows how much of your monthly income goes to your monthly housing-related expenses — specifically, your mortgage payment, property taxes, and mortgage insurance. Lenders typically allow you to spend a maximum of 28% of your monthly income on these costs.

The back-end DTI is where your student loans come into play because it calculates all of your monthly debt payments relative to your income. In most cases, lenders max out at 36% with your back-end DTI.

Because of the back-end DTI maximum, the amount of non-housing debt you have could impact how much you can afford with a new mortgage. For instance, if your student loan payment makes up 15% of your monthly income, you may be limited to 21% with the front-end DTI.

As a result, it’s important to understand how to run the numbers and how to lower debt-to-income ratio figures for your situation.

How to improve debt-to-income ratio numbers

There are only two variables when it comes to your DTI: your income and your debt payments. As such, the best way for how to lower your debt-to-income ratio is to increase your income or reduce your debt payments.

Here are some ideas that can help you achieve your goal:

  • Find a way to earn more money: Whether it’s switching jobs, taking on overtime work, or starting a side business, increasing your income means you have more money available to make monthly payments. Just keep in mind that self-employment income is viewed differently by mortgage lenders, and it can be difficult to include it if you haven’t been running your business for at least two years.
  • Pay off credit cards: Eliminating your credit card debt not only saves you money due to their pricey interest rates, but it can also reduce your DTI.
  • Pay off other debts: If you’re close to paying off an auto loan, personal loan, or even one of your student loans, it may make sense to tackle that debt before you apply for a mortgage loan. Even if the payment was relatively low, that’s still money that you could be putting toward your new mortgage loan without putting added stress on your budget.

Take a look at your situation and consider the best path forward based on the options available to you.

How to improve debt-to-income ratio through refinancing

Another excellent way to potentially lower your DTI is by refinancing your student loan debt. When you refinance student loans, you replace your current loans with a new one, usually from a different lender.

One of the biggest benefits of refinancing is that it can help you save on interest. If you can qualify for a lower interest rate than what you’re currently paying, you’ll be able to save money as you pay down your debt.

Scoring a lower interest rate can also naturally give you a lower monthly payment, which reduces your DTI and improves your chances of getting the loan you want.

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Even if you don’t qualify for a lower rate, or if you want an even lower monthly payment, you can also use refinancing to extend your repayment term — most private lenders offer up to 20 years, double the standard repayment plan.

Requesting a longer repayment term gives you more time to pay off the same balance, so your monthly payments will go down. The only drawback to consider is that you’ll end up paying more in interest over the life of your new loan, so weigh that against the benefits for your situation.

Also, if you refinance federal student loans, you’ll lose access to certain benefits through the U.S. Department of Education including forgiveness programs, income-driven repayment plans, and generous forbearance and deferment options.

If you can’t qualify for student loan refinancing on your own, consider asking a trusted family member or friend to help you by cosigning your loan. A creditworthy cosigner can help make your application seem less risky, improving your odds of approval. Even if you’re eligible on your own, adding a cosigner can help you score an even lower interest rate.

Shop around to get the best student loan refinance terms

If you’re considering student loan refinancing as a way to lower your debt-to-income ratio – and make your student debt repayment easier – make sure you compare at least three to five lenders to make sure you’re getting the lowest rate possible.

You can use the Purefy rate comparison tool to compare rate offers from multiple lenders without needing to visit each of their websites individually. As you shop around, keep in mind that many student loan refinancing lenders offer a wide range of repayment terms. Also, some may offer both fixed and variable interest rates.

As a result, it’s essential that you make sure you’re comparing the same repayment terms and types of interest rates across the board.

As you go through this process, you’ll learn about all the different opportunities available to you. Also, consider your situation and goals to help you determine whether refinancing is right for you, especially if you’re thinking about extending your repayment term.